Even if we capture 1% of the market

I have been on calls with founders who mention something along the following lines which always makes me wonder why aren’t they ambitious?

I understand that they want investors to visualise what 1% of a market will look like but it never entails their go-to-market strategy or the startup’s competitive advantage in terms of what is the gap in the market that incumbents got wrong that it becomes an adverse selection for them. Anchoring is a pure cognitive bias play and investors aren’t big fans of them. I believe the two reasons outlines below rejects the hypothesis that capturing 1% of the market is a viable approach to venture building.

Venture capital works on the notion of Power Law. In his book The Power Law: Venture Capital and the Making of the New Future, Sebastian Mallaby describes the power law as a statistical distribution in which a small number of extraordinary outcomes account for a disproportionately large share of the total returns. In venture terms, this means that a handful of company will provide extraordinary returns or have the capacity to return the venture fund and more.

Unlike in a normal distribution whereby the outcomes concentrate on the average, in a power law distribution, a handful of outliers will dominate the average.

Let’s retrace back to the notion of capturing 1% of a market, assuming the founder is pitching to investors at a $500 million venture fund. Suppose that the cumulative total addressable market is $1 trillion over the next 10 years, that means 1% translates to $10 billion in potential revenue over the same period. Let’s say the fund invests $20 million for a 10% stake and if left with 4% upon dilution. If the startup exits at a $10 billion valuation albeit achieving $10 billion in cumulative revenue, the venture fund walks away with only $400 million, or a 20 times return on its initial investments. Even when the founder had delivered on his promise, the single investment didn’t return the fund’s $500 million in committed capital.

Of course, this does not take into account the firm’s other investments. However impressive $400 million may be, this is without factoring in management fees, carried interest or the time value of money. This is why most investors aren’t a fan of the argument. Market share tells us something about the scale of the opportunity especially in a red ocean, but it explains very little about the economics of obtaining it or the returns that ultimately accrue to investors. This distinction is very important in venture capital especially when identifying a large market isn’t the same as identifying an investment capable of delivering the outcomes a fund needs.

This is a very straightforward argument. When you say capturing only 1% of the market will provide favourable returns, aren’t also implying that there is a possibility of competitors to enter the market and disrupt it? Investors back ambitious people but mentioning the 1% bit sound more pessimistic than optimistic.

Peter Thiel in his book Zero to One, argues that founders should aim to dominate a small market instead of competing for a fraction of a much larger one. He specifically cautions against the 1% argument because large markets tend to attract competition, which eventually bites into profits. Let’s consider two startups, once controlling 80% of a $100 million market and the other controlling 1% of an $8 billion market. Both these startups generate $80 million in revenue, but the former will have greater control over pricing and better defensibility. After all, the ability to retain value matters more than how much of a market you can capture.